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Issue XIX

April 1999

Sharp Investing

Why Value Investors are Different

The most valuable lesson from the fabulous 50-plus-year investment career of Warren Buffett is the account of his steadfast conviction amidst the 1973-1974 bear market. He had correctly identified by 1973 that the shares of companies such as the Washington Post were selling for only a fraction of the underlying business value. Buffett could acquire a minority interest in that business at a bargain price, but he could not force the valuation gap to close. For that, he was dependent on the passage of time to result in improved market conditions.

Fortunately for Buffett, the shares of the Post and other attractively priced companies failed to rise from 1973 bargain levels and in fact proceeded to relentlessly decline over the next two years enhancing the opportunity by an order of magnitude.

This episode is important because it illustrates what happens in declining markets and gives testimony to the wisdom and necessity of staying power: Had Buffett worried about the interim losses in 1974 or 1975 from his earlier and more expensive purchases, he might have not only failed to add to his holdings, but might also have panicked or been forced out of

his steadily dropping position. That he didn't reflects the conviction of a value investor - confidence in the eventual value of the business reflected in the stock price. Back in 1974 and '75 when his stocks were declining daily, Buffett at times must have wrestled with hindsight. Why hadn't he waited to begin his purchases until prices had bottomed? Prices were not in decline because the businesses were becoming worth less, but they were in decline because most investors were much more short-term oriented. They didn't want to hold securities that were declining in the short run, and Buffett was willing to do so. His eye was always on the far horizon, and the longer the stocks were in decline, the longer his buying opportunity.

Compare this with today's investor. They are overly worried about their short-term results even as they profess to be long-term investors. Professionals are even worse than individuals because of the way they are evaluated in the short-term. In such a world, relative short-term
*Value vs. Growth graph comes from 3/21/99 Oregonian. NYSE Breadth chart and DJIA chart come from Barron's.
underperformance is a disaster. Risk for professionals is not being stupid, but looking stupid. Risk is not overpaying, but failing to overpay for something everyone else holds. Risk is more about standing apart from the crowd than about getting clobbered, as long as you have a lot of company. Those that dare to defy the notion that it is okay to pay three or four times the historical valuation for a very small group of very popular stocks face the old adage: The standing nail gets hammered.

In 1998 investors were selling not Washington Post, but smallcaps, REITs and commodity-based stocks, even though they are all trading at record low valuations. Investors don't sell AOL at 450 times earnings because they love what it has done from them, no matter how expensive it has become. Mutual fund managers, desperate to put cash to work, don't buy what is cheap, but what is working now, since what is cheap by definition hasn't been working. But when stocks are rising for no better reason than that they have risen, the greater fool is at work.

Buying stocks with no earnings or declining earnings (S&P 500 earnings declined 1.8% in 1998 while the rest of the market experienced earnings growth) is a strategy based on guessing how the market will regard the investment in the future, rather than buying a dollar's worth of a company for 50 cents.

A nation that reveres Warren Buffett has essentially disavowed his investment style to chase expensive stocks.
This trend has produced some rather astonishingly high valuations. The 100 largest stocks on the Nasdaq now sell for over 100 times earnings. The 50 largest stocks in the S&P500 now sell for over 50 times earnings. Normally, such elevated valuations would put off investors and encourage them to seek cheaper alternatives, but disregard for absolute price as an investment consideration has become a hallmark of the current market. The insensitivity to price has even spread to the public sector. When Alan Greenspan expressed his concern about "irrational exuberance" at 6300 on the Dow, he received so much criticism that even though prices have risen more than 50% from those levels, he now speaks in highly subjective tones as to whether the market may be overvalued.

Eventually this will begin to unwind as some participants become concerned and start to break ranks and sell their positions, fearing that they must act before others do. The subsequent underperformance then will challenge the confidence of others who have held the same positions only because the strategy was working. As more investors try to leave at the same time, things deteriorate quickly. Prices drop sharply because, in their hearts, everyone knows the positions to be overvalued.

It is at this point that the Warren Buffetts of this world that have forsaken following the madness of crowds will once again prove that the more things change, the more they stay the same. People will look back upon the last several years with 20-20 hindsight as they have with all great deviations from normal valuation in the past and wonder what in the world investors were thinking. And as the gap closes between business

value and business stock price, the cycle will start all over again as it always has over the past 400 years of financial markets.

Value investors are different because they put more credence on the 400 years of financial market history than on the past two or three years of abnormal market history.

Smallcap Value (Small) versus Largecap Growth (Big)

In last quarter's issue of Sharp Investing, we examined the normal risk-return relationship of stocks, and how it has been turned on its head over the past several years. Smallcap value stocks, which have produced 18.5% return over the past 35 years, have produced below average returns for the past several years, and largecap growth stocks, which have averaged 10.8% return over the past 35 years, have produced nearly triple their long-term return over the past several years.

Nowhere is this more evident than in 1998, when smallcap value stocks declined over 10% and largecap growth stocks again appreciated at more than double their long-term rate of return. This disparity in returns over the past several years has lead to some astounding differences in valuation; largecap growth stocks are valued at almost triple the premium that investors have given them over the past 50 years, while smallcap value stocks are at their lowest valuations ever, in spite of having faster growth rates, better earnings, and less exposure to the slowing world economy.

Putting aside all the reasons for this disparity, a look at history shows us what has happened in the past when smallcap value has had a dismal year, or when largecap growth has had several years of abnormally high returns.

Below are the returns for the year following two consecutive years of above average returns for largecap growth stocks

Year Return% Next Yr's return %
1964 - 1965 16.7, 15.8 -11.0 in 1966
1971 - 1972 23.6, 21.6 -20.3 in 1973
1975 - 1976 35.7, 18.4 - 9.1 in 1977
1979 - 1980 20.7, 18.9 - 7.9 in 1981
1982 - 1983 17.6, 16.2 - 1.1 in 1984
1985 - 1986 31.4, 13.7 6.4 in 1987
1988 - 1989 12.8, 31.5 1.4 in 1990
1995 - 1996 37.9, 21.2 30.3 in 1997
  Average - 1.4%

Below are the returns for the two years following a single year of negative returns for the smallcap value stocks:

Year Return% Next Two Yr's annual return %
1966 - 5.5 75.6, 42.6
1969 -23.9 .3, 14.4
1974 -18.2 54.5, 53.6
1987 - 6.3 28.8, 19.6
1990 -20.8 39.4, 31.1
1998 -10.0 ???
  Average 36.0%

To summarize, there have been eight periods out of the last 35 years in which largecap growth stocks had above-average returns for two years in a row. The average return for the growth stocks the next year was -1.4%

There have also been six periods in the last 35 years in which smallcap value stocks have had negative returns. For each of the next two years following a negative year, the value stocks produced an average return of 36% each year.

This is just one of the reasons why I feel the future is still in value stocks in spite of the continued investor interest in the "dotcom" stocks, and is also why the value stocks have returned 18.5% return over the past 35 years compared to the 10.8% return of the growth stocks.

Bad Breadth in Today's Markets

Breadth is a term in investing used to describe how stocks are doing beyond the 30 stocks that make up the Dow Jones Industrial Average. The Dow contains only 1/3 of a percent of the publicly traded companies in the United States. The other 9,970+ companies out there can be priced about the same as the Dow, or more or less than the Dow.

From the chart below you can see two completely different pictures of how the "Market" is doing. If you consider the Dow to be the market, you see an appreciation of about 10% over the past 12 months.
If you consider all the stocks traded on the NYSE (about 4000 companies), while not as big as the Dow in size, still bigger on average than Nasdaq or Amex traded stocks, you see the "average" stock is nowhere near up 10% over the past 12 months. How unusual is this?

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In the bear market of 1973-1974, about 60% of stocks traded more than 15% below the Dow. In the bear market of 1990, about 50% of stocks traded more than 15% below the Dow. Today? For the first time ever in history, over 75% of stocks are trading at 15% below the equivalent levels of the Dow. In 1974, when this ratio was near 60%, at the time the highest ever, the Dow went on to lose
45.1% of its value while the broad market had two consecutive years of over 50% returns to close the gap in valuation between the "Nifty Fifty" and the rest of the market.

Bad Breadth has a way of self-correcting. To quote Horace's Ars Poetica: "Many shall be restored that now are fallen and many shall fall that are now in honor."
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